Board of Governors of the Federal Reserve System
International Finance Discussion Papers
Number IFDP 1042, February 2012 --- Screen Reader
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Monetary Policy in Emerging Market Economies: What
Lessons from the Global Financial Crisis?

Brahima Coulibaly

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Abstract:

During the 2008-2009 global financial crisis, emerging market economies (EMEs) loosened monetary policy considerably to cushion the shock. In previous crises episodes, by contrast, EMEs generally had to tighten monetary policy to defend the value of their currencies, to contain capital flight, and to bolster policy credibility. Our study aims to understand the factors that enabled this remarkable shift in monetary policy, and also to assess whether this marks a new era in which EMEs can now conduct countercyclical policy, more in line with advanced economies. The results indicate statistically significant linkages between some characteristics of the economies and their ability to conduct countercyclical monetary policy. We find that macroeconomic fundamentals and lower vulnerabilities, openness to trade, and international capital flows, financial reforms, and the adoption of inflation targeting all facilitated the conduct of countercyclical policy. Of these factors, the most important have been the financial reforms achieved over the past decades and the adoption of inflation targeting. As long as EMEs maintain these strong economic fundamentals, continue to reform their financial sector, and adopt credible and transparent monetary policy frameworks such as inflation targeting, the conduct of countercyclical monetary policy will likely be sustainable.

Keywords: Monetary policy, crises, macroeconomic stabilization

JEL classification: E52, E58, E63

1 Introduction

During the financial crisis of 2008-2009, emerging market
economies (EMEs) loosened monetary policy considerably to cushion
against the global financial shock and to foster economic recovery.
This is a remarkable departure from previous crisis episodes during
which EMEs generally had to raise interest rates in order to
bolster the credibility of monetary policy, to defend the value of
their currencies, and to contain capital flight. Our study asks
what factors enabled this shift in monetary policy of EMEs, and it
assesses whether this shift marks a new era in which EMEs can
pursue countercyclical monetary policy like their counterparts in
advanced economies.

Macroeconomic policies-both fiscal and monetary-tend to be
countercyclical in advanced economies. In EMEs, by contrast, these
policies tend to be procyclical or, at best, acyclical that tend to
be countercyclical. This feature of monetary and fiscal policy
deprived EMEs of important macroeconomic stabilization tools, and
might partly explain the higher volatility of output in EMEs
compared with the advanced economies documented in Aguiar and Gopinath (2007) and
others. One way to reduce output volatility and enhance welfare in
EMEs is to understand the factors that prevented policymakers in
EMEs from conducting countercyclical policy in the past, and to
devise policies to help them use fiscal and monetary policy for
macroeconomic stabilization.

Studies have analyzed the factors driving the cyclicality in the
fiscal policy of EMEs. See for example, Gavin and Perotti (1997), Talvi and Vegh (2004), and
others.1 By contrast, there are few empirical
studies of the cyclicality in the monetary policy in EMEs. This
sparsity likely reflects the difficulty of finding common monetary
policy instruments over time and across countries, as these
instruments depend importantly on the exchange rate regime. Even
with common instruments, characterizing the monetary policy stance
is difficult.

In Kaminsky, Reinhart, and Vegh (2004) examines cyclicality in the monetary
policy of a broad set of countries covering both emerging market
and advanced economies by relying primarily on short-term interest
rates. Assuming imperfect substitution between domestic and foreign
assets, short-term interest rates can represent common monetary
policy instruments under both flexible and predetermined exchange
rate regimes. Using these short-term interest rates, Kaminsky et
al. (2004) estimate a Taylor rule policy function for each country
and find that monetary policy is generally countercyclical in
advanced economies. By contrast, it tends to be procyclical in
EMEs.

Kaminsky, Reinhart, and Vegh (2004) did not explore the factors
preventing EMEs from conducting countercyclical monetary policy.
These factors were explored in Calderon et al. (2003) for a set
of eleven EMEs. They find that the ability of these EMEs to conduct
both countercyclical fiscal and monetary policies is determined by
the credibility of their policies.

Our study adds to this sparse literature by examining the
behavior of monetary policy during economic crises. Economic crises
are costly in output and welfare losses. Optimal response to crises
generally require countercyclical policies to cushion the shock and
to foster economic recovery. Yet in EMEs, the crises are
exacerbated by procyclical policies, including monetary policy.
However, during the 2008-2009 global financial crisis, central
banks in EMEs were able to loosen monetary policy considerably,
perhaps signaling that monetary policy has evolved in these
countries. To our knowledge, this is the first study to
comprehensively assess the factors that determined the cyclicality
of monetary policy during the 2008-2009 financial crisis, and
during crises more generally.

We construct a large dataset for 188 advanced and emerging
market countries from 1970 through 2009. We identify 1,462
financial and economic crisis years, and examine the behavior of
monetary policy during those crises. The results confirm that
advanced economies have historically conducted countercyclical
monetary policy during crises while EMEs tended to tighten monetary
policy. However, the difference in policy response between the two
sets of countries has been fading. In the most recent decade,
notably during the 2008-2009 crisis, EMEs have generally conducted
countercyclical policy like their counterparts in the advanced
economies.

Our estimation strategy uses a Logit regression model to examine
the factors that have facilitated the conduct of countercyclical
monetary policy in EMEs. The results indicate statistically
significant linkages between some characteristics of the economies
and policymakers' ability to conduct countercyclical monetary
policy. We find that while stronger macroeconomic fundamentals,
reduced vulnerabilities, greater openness to trade and
international capital flows facilitated the conduct of
countercyclical policy, the most important determinants have been
the financial reforms achieved over the past decades and the
adoption of inflation targeting. Inflation targeting regimes, which
are becoming more pervasive among EMEs, enhance greater policy
transparency and flexibility of monetary policy. EMEs also achieve
greater policy credibility by adopting inflation targeting regimes
and by achieving greater financial reforms. As long as EMEs
maintain strong economic fundamentals, continue to reform their
financial markets, and adopt credible and transparent monetary
policy frameworks such as inflation targeting, the conduct of
countercyclical policy as an economic stabilization tool might be
sustainable.

The remainder of the paper is organized as follows: In the next
section, we discuss some of the literature on the determinants of
monetary policy stance in EMEs. Sections 4 and 5 describe the
econometric strategy, the data, and the results. Section 5 is
devoted to caveats and robustness analyses, and we offer concluding
remarks in Section 6.

During economic crises the common policy prescription is to
loosen monetary policy in order to support domestic economic
activity. This prescription is theoretically motivated by the
Keynesian models and illustrated in practice by the Taylor rule
type of approach to monetary policy. In this setting, looser
monetary policy is necessary to help close the negative output gap
and restore full employment. The consequent increase in domestic
liquidity tempers the effect of the contraction in external credit
that usually occurs during EMEs' crises. Advanced economies have
generally followed this practice. In EMEs, however, other factors
have prevented the conduct of countercyclical policy or made
countercyclical policy undesirable.

Conditional on specific economic vulnerabilities,
countercyclical policy might not be optimal. For example, if a
country has a large fraction of its debt that is short term and
denominated in foreign currency, the adverse balance sheet effects
of an exchange rate depreciation induced by a countercyclical
policy could more than offset any potential costs of a procyclical
policy. In this case, it would be optimal to maintain a procyclical
monetary policy. Internal vulnerabilities such as these or other
institutional deficiencies explain the inability or undesirability
of policymakers in EMEs to conduct countercyclical policy. And
authorities in these countries have often been more concerned about
bolstering the credibility of policy, containing capital flight,
and defending the values of their currencies.

A study by Calderon et al.(2003) of the cyclicality of monetary policy in some EMEs,
finds that credibility of policy was the determining factor. As
pointed out by Lane (2003), when
the monetary authority lacks credibility, a temporary loosening of
monetary policy is perceived as heralding a persistent switch to a
loose money regime with adverse effects on confidence and increases
in risk premiums demanded by foreign investors.2

We include in our study some variables that capture the strength
of institutions and the credibility of policy: the exchange rate
regime, an indicator for inflation targeting, a measure of
financial reforms-the extent to which authorities have allowed
market forces to determine outcomes in credit and financial
markets-, and a measure of financial development.

In addition to measuring strength of institutions and the
credibility of policy, the financial development variable has a
unique relevance. Financial development enables a more efficient
transmission of monetary policy and, hence, increases the
incentives to conduct countercyclical policy. Also, the development
of financial markets has traditionally promoted more borrowing on
domestic markets and in local currencies. A higher share of local
currency debt reduces risks of capital flight, and risks of
currency and maturity mismatches. As such, development of domestic
financial markets facilitates the conduct of countercyclical
policy.

Devereux and Lane(2003) finds that countries with a greater dependence on
foreign currency debt are more likely to tailor policy to minimize
exchange rate volatility with the creditor country. Besides
restricting monetary policy, dependence on external debt and debt
with shorter maturities has affected the perceived solvency of EMEs
during crises. With this consideration in mind, we include
variables on external debt and its maturity structure and variables
on the country's finances such as foreign exchange reserves and
central government debt.

We also consider other macroeconomic fundamentals such as
current account balances and inflation. A low inflation environment
facilitates the loosening of monetary policy, consistent with the
prescriptions from a Taylor rule function. Inflation could also
capture the independence of the central bank and, hence,
credibility of monetary policy. Several studies document that
central banks in lower-inflation countries are more independent
(see for example, Alesina and Summers, 1993); and central bank
independence improves the efficiency of monetary policy (Mishkin,
2010).

Economic integration is also an important factor. A study by
Yakhin (2008) finds that under
financial integration, the optimal monetary policy is
countercyclical, but procyclical under autarky. These results
suggest an important role for openness. We include a measure of
financial openness, and also trade openness.

In sum, the variables we explore in this study can be classified
into four categories: Macroeconomic fundamentals and
vulnerabilities, openness, monetary policy and exchange rate
framework, and financial development and reforms. These variables
are not independent of each other and the categories are likely not
insular. In the empirical analysis, we assess the statistical link
between monetary policy and these variables in both univariate and
multivariate econometric frameworks.

In this section, we analyze monetary policy during the 2008-2009
global crisis. At the height of the crisis, between the third
quarter of 2008 and the end of the first quarter of 2009, over 80
percent of EMEs loosened monetary policy. In the analysis that
follows, we assess the factors that enabled most, but not all,
countries to loosen monetary policy.

3.1 Econometric Specification and Data
Description

We estimate the following Logit model using the indicator
variable for countercyclical monetary policy during crises as the
dependent variable:

(1)

A country is considered to have conducted countercyclical
monetary policy during the crisis if the cumulative change in the
monetary policy rate between the third quarter of 2008 and the end
of the first quarter in 2009 is negative. is
the indicator variable for whether country has, on
net, lowered its monetary policy rate between the third quarter of
2008 and the end of the first quarter in 2009.
represents the set of variables that determine the conduct of
monetary policy. They are measured in in 2007- the year prior to
the crisis.

Macroeconomic Fundamentals and Vulnerability: and are the foreign
exchange reserves and current account balance as percent of GDP,
respectively. is the central government debt as
percent of GDP. is the annual change of the
consumer price index.
and
represent short-term external debt as percent of total external
debt and foreign exchange reserves, respectively.

Openness: and capture the degree of trade and financial openness,
respectively. Trade openness is the the sum of imports and exports
as percent of GDP. For financial openness, we use the Chinn-Ito
index of capital account openness. It was initially introduced in
Chinn and Ito (2006) and subsequently updated by the authors
through 2008. The index is based on the tabulation of binary dummy
variables that capture restrictions on cross-border financial
transactions as reported in the IMF's Annual Report on Exchange
Arrangements and Exchange Restrictions (AREAER). It varies from
-1.8 to 2.5, with higher numbers indicating greater financial
openness.3

Exchange Rate Regime and Policy Credibility: is an indicator variable for whether the country's central
bank is an inflation targeter in a given year. captures the rigidity of the exchange rate regime
based on the classification in the IMF's AREAER. For a given year,
each country is assigned a number between 1 and 5, with higher
numbers indicating greater flexibility of the exchange rate
regime.

Financial Development and Financial Reforms: measures financial development based on data for bank
deposit, financial system deposits, deposit banks' assets, and
credit extended by banks and total credit to the domestic economy.
We then divide these variables by GDP and conduct a principal
component analysis to obtain a single index. The resulting factor
(index) is highly correlated (0.92 or higher) with the variables,
and explains 93 percent of the variability of these variables.
measures financial reforms. It is an
index constructed by Abiad et al. (2008) based
on factors such as the extent of directed credit, level of reserve
requirements, prevalence of credit controls and credit ceilings,
interest rate controls, entry barriers, capital account
restrictions, state ownership in banking sector, and prudential
regulations and supervision of the banking sector. The index
provides a number ranging from 0 to 21, with higher values
indicating greater degrees of financial reform. See Abiad et al. (2008) for
details. In this study, we use the normalized (between 0 and 1)
version of the index, also provided by the authors. The reforms
index has a high autocorrelation coefficient of . We use an process to impute the
missing values for 2006 and 2007.4 Table 1 presents summary statistics for the
variables described above for the the 2008-2009 subsample.

Figures 1 through 2 plot the median or mean values of some key
variables through 2007 for the set of countries that lowered their
policy rates (the bold line) and the set of those that did not (the
thin line). Several of these key variables highlight the difference
between the two sets of countries. Those that loosened monetary
policy had better macroeconomic fundamentals and lower
vulnerabilities: inflation was lower on the eve of the crisis;
current account balances were in large surplus while those of
countries that could not lower rates were in deficit; reserves as
percent of GDP were higher, and central government debt as percent
of GDP was lower. Also, compared with countries that could not
lower rates, those that did had external debt with slightly longer
maturities, and lower short-term debt as percent of reserves. They
were also more open to trade and international capital flows, had
relatively more flexible exchange rate regimes, and were more
likely to be inflation targeters. Finally, countries that lowered
monetary policy had more developed financial markets and had made
more progress on financial reforms.

To facilitate interpretation of our regression results, we
transform all of the continuous variables into categorical
variables: top quartile, midquartiles, and bottom quartile. This
transformation also allows for the exploration of nonlineraties and
to control for the effect of potential outliers.

3.2 Estimation and Results

3.2.1 Univariate Analysis

The regression results for the univariate analysis (each
regression has only one explanatory variable) are shown in Table 2. Columns 2, 3, and 4 show
the logit coefficients, p-values, and odds ratios,
respectively.

Macroeconomic Fundamentals and Vulnerability: These
results suggest that strong macroeconomic fundamentals and reduced
vulnerability in the pre-crisis year increased the chances of
conducting countercyclical monetary policy. A country with
pre-crisis inflation in the top quartile of the distribution has
lower odds of reducing rates during the crisis. Similarly,
countries with the lowest government debt and highest current
account surplus (in the top quartiles) were, respectively, about
2.3 and 3.5 times more likely to conduct countercyclical policy.
The coefficients for the share of short-term external debt, foreign
exchange reserves as percent of GDP, and short-term debt as percent
of foreign exchange reserves have the expected sign, but they are
not statistically significant.

Openness: The next set of results indicates an important
role for openness in a country's ability to conduct countercyclical
monetary policy. Countries with highly open capital accounts (top
quartile of the distribution) were 3 times more likely to loosen
monetary policy during the 2008-2009 crisis. Similarly, those most
open to trade on the eve of the crisis were 2.5 times more likely
to loosen monetary policy.

Exchange Rate Regime and Policy Credibility: The
coefficient for the exchange rate regime has the expected sign;
countries with the most flexible form of exchange rate regime are
more likely to loosen monetary policy but the coefficient is not
statistically significant. The results for inflation targeting,
which also proxies for transparency and credibility of the central
bank, are very strong. A country with an inflation targeting regime
was about 7.6 times more likely to conduct countercyclical monetary
policy than a country without one.

Financial Development and Financial Reforms: The result
for financial reform is also very strong. It suggests that a
country with the highest level of financial reform was 4.5 times
more likely to loosen monetary policy. For financial development,
the positive coefficient has the expected sign though it is not
statistically significant.

We suspect that these variables are not necessarily independent
of each other. In the next analysis, we estimate the effect of
these various factors in a multivariate econometric framework.

3.2.2 Multivariate Analysis

Tables 3 presents the odds ratios
obtained from the multivariate regression using equation (1). We estimate the model with OxMetrics, a
statistical software package that explores various combinations of
regressors to maximize the fit of the model based on the Akaike
Information Criterion.5 At the outset, it suggested 5
alternative models-Columns (1) through (5). Overall, the results
are consistent with those of the univariate analysis. Countries
with the lowest level of government debt on the eve of the crisis
were about 2.5 times more likely to loosen monetary policy. Those
that were most open, particularly to capital flows, had greater
odds of conducting countercyclical monetary policy. Inflation
targeting remains the most important determinant of a country's
ability to conduct countercyclical policy. The results are strong
and consistently robust across various specifications.

In sum, the analysis provides evidence of links between EMEs'
ability to conduct countercyclical policy during the crisis and
some pre-crisis characteristics of their economies, such as level
of government debt, degree of openness, and most importantly,
inflation targeting monetary policy framework. This remarkable
development begs the following question: Is the ability of EMEs to
conduct countercyclical policy during the 2008-09 crisis ephemeral
or is it a reflection of structural improvements that have enabled
monetary policy to become a more effective macroeconomic
stabilization tool? In the next set of analyses, we explore the
determinants of countercyclical monetary policy in EMEs more
generally by expanding the sample to the preceding four
decades-1970 through 2009.

In this section, we explore more generally the determinants of
countercyclical monetary in EMEs over the past four decades.

4.1 Identification of Crises and Monetary
Policy Stance

Two variables that are central to our study are indicators for
crises and the monetary policy stance. We follow Frankel and Rose (1996) and define
a crisis year as one in which the bilateral U.S. dollar exchange
rate depreciated at least 25 percent, with the rate of depreciation
exceeding the previous year's depreciation by at least 10
percentage points.6 In addition, we include periods with
negative or zero real gross domestic product (GDP) growth in order
to capture episodes of economic stress that necessitate active
countercyclical monetary policy, but when exchange rate movements
might not be substantial. At the outset, we obtain 1,462 episodes
between 1970 and 2009. Figure 3 provides a histogram for the distribution of the crises episodes
over time. The year 2009 stands out as having the most crises.
There were also a higher number of crises in the early 1980s and
1990s. This tabulation is consistent with well-known economic and
financial crises that have affected the global economy, including
the sovereign debt crises of the early 1980s, the Savings and Loans
crisis and the Japanese banking crisis of the 1990s.

Identifying the monetary policy stance is more complicated,
primarily due to the lack of a common monetary policy instrument
across countries and time. In particular, the policy instrument
depends on the exchange rate regime. We follow Kaminsky, Reinhart, and Vegh
(2004) and use short-term interest rates as the policy
instrument. Under flexible exchange rate regimes, short-term
interest rates characterize monetary policy since changes in money
supply influences these rates. However, under predetermined
exchange rate regimes, short-term rates are valid monetary policy
instruments only if we assume imperfect substitution between
domestic and foreign assets. See, for example, Flood and Jeanne (2000) or Lahiri
and Vegh (2003). For the choice of short-term rates, we begin with
the monetary policy rates, and supplement with the discount or
interbank rates. When these series are not available, we rely on
short-term Treasury bill rates, and then money market rates.

In addition to short-term interest rates, we also use growth of
central banks' domestic credit to proxy for monetary policy. Under
flexible exchange rate regimes, central bank domestic credit growth
affects the monetary base and short-term rates. Under predetermined
exchange rate regimes and perfect substitution between domestic and
foreign assets, growth in central bank credit will be offset by an
opposite effect in foreign exchange reserves. However, if domestic
and foreign assets are imperfect substitutes, an increase in
central bank credit will have some effect on the monetary base and
short-term interest rates.

Even with good measures of the monetary policy instrument,
characterizing the monetary policy stance is not obvious. For the
purpose of this study, we define countercyclical policy as a
movement in the direction of loosening monetary policy during
periods of economic stress. We define a binary indicator variable
that takes a value of one if: the policy rate declines in the year
of the crisis relative to the previous year or when the central
bank's domestic credit growth in the crisis year exceeds that of
the previous year and the average rate of the three years prior to
the crisis. When the monetary policy rate is not available, we rely
on other short-term rates.

We are mindful of the potential imperfections associated with
the use of other short-term interest rates to as a measure of
monetary policy. Short-term rates can change independent of the
true monetary policy rate. For example, risk premia tend to
increase during crises, causing some short-term rates to rise even
if policy rates have been lowered. However, in periods of crises,
we posit that a decline in short-term rates likely indicates lower
monetary policy rates. At the outset, we obtain the policy stance
for 980 crisis years, 127 for the advanced economies and 853 for
EMEs.

Figure 5 presents the frequency
countercyclical monetary policy during crises over time and for the
two sets of countries. The figure highlights the contrast between
the advanced economies and EMEs. While the advanced economies have
traditionally conducted countercyclical monetary policy during
crises, it is only in the latter periods that EMEs began to do so.
During crises in the 1970s, EMEs lowered rates in only about 30
percent of the crises. This fraction has increased steadily, to 70
percent in the most recent decade. During the 2008-2009 global
crisis, the fraction rose further, to over 80 percent.

4.2 Econometric Specification and Data
Description

The econometric model is a more general version of equation
(1) used in the previous section.

(2)

Where
;
represents a set of explanatory
variables that capture a country's ability to conduct
countercyclical monetary policy during crises and are measured in
the year before the crisis () for each
crisis country . The set of independent variables
are as defined in the previous section,
but measured with a lag. Summary statistics for the independent
variables over the 1970-2009 sample period are described in Table 1.

4.3 Estimation and Results

4.3.1 Univariate Analysis

Table 4 presents the regression
results for the univariate model. They are generally similar to
those in Table 2.

Macroeconomic Fundamentals and Vulnerability: Strong
macroeconomic fundamentals and reduced vulnerability increase the
chances of conducting countercyclical monetary policy. A country
with pre-crisis inflation in the bottom quartile of the
distribution is 62 percent more likely to reduce rates during the
crisis. Similarly, countries with the largest amount of foreign
exchange reserves (in the top quartile) are about 2.5 times more
likely to conduct countercyclical policy. Those with the highest
levels of short-term external debt to foreign exchange reserves
ratio are less likely to conduct countercyclical policy during
crises. The coefficients on the share of short-term external debt,
current account surpluses, and government debt have the expected
sign but are not statistically significant.

Openness: The next set of results examine the role of
openness. Overall, they suggest an important role for openness in a
country's ability to conduct countercyclical monetary policy.
Countries with highly open capital accounts (top quartile of the
distribution) are 45 percent more likely to loosen monetary policy
during crises. Similarly, those most closed to trade are about 40
percent less likely to loosen monetary policy.

Exchange Rate Regime and Policy Credibility: The
coefficient for the exchange rate regime has the expected sign;
countries with the most flexible form of exchange rate regime are
more likely to loosen monetary policy but the coefficient is not
statistically significant. Again, the results for inflation
targeting, which also proxies for transparency and credibility of
the central bank, are the strongest. They suggest that a country
with inflation targeting is nearly 7 times more likely to conduct
countercyclical monetary policy than a country without an inflation
targeting regime.

Financial Development and Financial Reforms: Both
financial development and reforms enhance the ability to conduct
countercyclical monetary policy. Countries that have achieved the
highest level of financial reforms are more than twice as likely to
loosen monetary policy, and those with the most developed financial
system are 50 percent more likely to loosen monetary policy.

In sum, these results suggest strong linkages between a
country's ability to conduct monetary policy and its macroeconomic
fundamentals and vulnerability, its degree of openness, the
exchange rate regime and the credibility of the central bank's
policy, as well as the degree of financial development and reforms.
Judging by the size of the coefficients, inflation targeting
appears to be the most important determinant of the ability to
conduct countercyclical monetary policy, followed by a high level
of financial reforms, large amounts of foreign exchange reserves,
and low inflation.

4.3.2 Multivariate Analysis

Table 5 presents the odds ratios
obtained from the multivariate regression using equation (2). We estimate the model with OxMetrics. It
explored 450 models (combinations of regressors), and selected,
based on the Akaike Information Criterion, the 12 comparable
alternative models reported in columns 1 through 12 of the
table.

Macroeconomic Fundamentals and Vulnerability: As found
previously, stronger macroeconomic fundamentals and low
vulnerability enhance the odds of countercyclical monetary policy.
Countries with the lowest pre-crisis rate of inflation are more
than twice as likely to lower interest rates during crises. These
results are consistent with the prediction from a Taylor rule
reaction function. Indeed, in a low inflation environment, monetary
authorities can loosen monetary policy to stimulate economic
activity without concerns of fueling inflation. We find evidence
that higher foreign exchange reserves as a percent of GDP enhance
the odds of conducting countercyclical monetary policy. Having
foreign exchange reserves to cover the external short-term debt is
a robust indicator of a country's ability to conduct
countercyclical monetary policy. Countries in the lowest quartile
of the short-term debt to foreign exchange reserves distribution
are roughly twice as likely to conduct countercyclical monetary
policy, and the effect appears to be monotonic. The extent to which
a country can cover its short-term debt is indeed an important
indicator of its solvency in periods of crises when the rollover of
debt or issuance of new debt becomes difficult.

Openness: In one of the specifications, we find evidence
that financial openness increases the likelihood of countercyclical
monetary policy. Countries most open to trade are 50 percent more
likely to loosen monetary policy during a crisis. The coefficient
for trade openness has the expected sign but it is not
statistically significant.

Exchange Rate Regime and Policy Credibility: The
coefficient for the exchange rate regime is statistically
insignificant. By contrast, as documented previously, inflation
targeting remains the most robust predictor of a country's ability
to conduct countercyclical monetary policy. Inflation targeters are
about 6-to-11 times more likely than non-targeters to loosen
monetary policy during a crisis, and this effect is consistently
robust across the various alternative models.

Financial Development and Financial Reforms: The
coefficient for financial reforms is robust across a number of
alternative specifications. Countries with the highest level of
financial reforms are roughly 3 times more likely to conduct
countercyclical monetary policy. The results for financial
development are not significant in a number of cases but, where
significant, they are counter-intuitive.

5 Caveats and Robustness
Analysis

In this section, we conduct robustness analysis to assess the
importance of some of the assumptions we have made and discuss some
possible caveats.

During the analysis, as in Kaminsky, Reinhart, and Vegh
(2004), we assume that under imperfect substitution between
foreign and domestic assets, short-term interest rates are good
monetary policy instruments under predetermined exchange rate
regimes. To assess how this assumption affects our results, we
restrict the sample to non-pegged exchange rate regimes in the
first robustness test. The second test, we restrict the measurement
of monetary policy to policy rates and discount rates only-the two
most reliable measures-in order to control for the effect of
potential imperfections in other measures of monetary policy. In
the third robustness test, we remove from the sample crises
episodes during which policy was acyclical-when interest rates did
not change between the pre-crisis year and crisis year. In the last
robustness test, we remove from the sample the second of any two
crises that occur in consecutive years for the same country to
ensure that our results are not driven by a possible doublecounting
of the same crisis. The results for these robustness analyses are
presented in Table 6, column 1, 2,
3, and 4, respectively. Our main results, highlighting the
importance of financial reforms and inflation targeting regimes on
a country's ability to conduct countercyclical monetary policy,
still hold.

One caveat is whether nominal interest rates (not real interest
rates) are the appropriate measure of monetary policy stance. We
are unable to measure inflation expectations and formally conduct
this robustness analysis. Our study is more concerned with the
direction of monetary policy from the standpoint of the central
bank and not with the actual policy stance. As such, the use of
nominal interest rates is appropriate.

Another caveat pertains to the other nonconventional monetary
policy instruments that EMEs often use. In advanced economies with
well-functioning financial markets, the main monetary policy
instrument consists of open market operations and, to a lesser
extent, adjustments to the discount rate and reserve requirement
ratios. In EMEs, where financial markets are underdeveloped,
monetary policy use other nonconventional instruments such as
credit ceilings, and moral suasion. Although this study does not
take into account all of the measures of monetary policy, we
believe that if data were available, changes in these instruments
would generally be consistent with the changes in short-term rates.
For example, it is not likely that the central bank will lower
short-term interest rates and at the same time raise reserve
requirements or lower the credit ceilings.

We further assured that our main results are robust to a number
of the caveats mentioned earlier by the consistency between the
analysis over the 1970-2009 sample and the 2008-2009 sub-sample. In
the 2008-2009 sub-sample, we have better measures of the monetary
policy rates and, hence, rely less on other short-term interest
rates as proxies for policy rates. Moreover, fewer countries had
pegged exchange rate regimes suggesting that the assumption of
imperfect substitution domestic and foreign assets is not as
necessary. Finally, one might be concerned about the effect of
differences in nature of crises in our sample 1970-2009. Again, we
are comforted by the consistency of the results obtained from the
two samples. The cross-section analysis that uses only the
2008-2009 sub-sample allows us to control for the nature of the
crisis and identify the determinants of countercyclical policy
through cross-country variations.

6 Concluding Remarks

During the recent global financial crisis, a large number of
EMEs loosened monetary policy to cushion the effect of the global
financial crisis. This was a remarkable departure from previous
crisis episodes during which EMEs had to tighten monetary policy.
In this study, we explored the factors that enabled this shift in
policy stance and find statistically significant linkages between
some characteristics of the economies and their ability to conduct
countercyclical monetary policy.

The results indicate that stronger macroeconomic fundamentals
and reduced vulnerabilities, greater openness to trade and
financial flows, financial reforms and the adoption of inflation
targeting all facilitated the conduct of countercyclical policy in
EMEs. Of these factors, financial reforms and inflation targeting
stand out as the most important. Several EMEs adopted inflation
targeting since the late 1990s and, over the past decades, EMEs
have also reformed their financial sectors. Inflation targeting
regimes enhance transparency and flexibility of monetary
policy.

By adopting inflation targeting and by implementing financial
reforms, EMEs also achieved a greater policy credibility. Indeed,
lack of policy credibility is one of the main impediments to EMEs'
ability to conduct countercyclical monetary policy. When
credibility is fragile, an attempt by the central bank to loosen
monetary policy is perceived as a permanent switch to a loose money
regime. This perception adversely affects confidence and increases
risk premiums demanded by foreign investors. The adoption of
inflation targeting helps to dispel these perceptions, as it
fosters confidence in monetary policy and anchors inflation
expectations. Moreover, inflation targeting has been accompanied by
reduced emphasis on exchange rate management, thereby allowing
monetary policy to be flexibly geared toward the stabilization of
the domestic economy.

We interpret our results to suggest that as long as EMEs
maintain strong economic fundamentals, continue to reform their
financial markets, and adopt flexible and transparent monetary
policy frameworks such as inflation targeting, the conduct of
countercyclical policy as an economic stabilization tool will
likely be sustainable. The increasing popularity of inflation
targeting among EMEs is particularly encouraging in this regard. We
are not aware of a country that has adopted inflation targeting and
abandoned it out of dissatisfaction, and there appears to be a
degree of irreversibility in financial reforms, suggesting that the
conduct of countercyclical policy could be sustainable.

The increasing ability of EMEs to use monetary policy as a
macroeconomic stabilization tool might partly explain the greater
resilience of these economies to shocks emanating from the advanced
economies despite increasing integration between the two sets of
countries.

7 Appendix: Variables and Data
Sources

INTREST RATES

International Financial Statistics (IFS), Haver
Analytics

CENTRAL BANK CREDIT

IFS

INF

IFS, World Development Indicators database
(WDI)

FXR2GDP

IFS, WDI

MATEXTDT

WDI

CAB2GDP

WDI

CGD2GDP

WDI and IMF Historical Public Debt database

STDT2EXTDT

IFS, Global Development Finance database

STDT2FXR

Global Development Finance database, IFS

OPENTRADE

WDI

OPENFIN

Chinn-Ito Index database

IT

National sources

EXCHREG

Ilzetzki, Reinhart, and Rogoff (2008)
database

FINREF

Abiad et. al (2010) Financial Reforms
database

FINDEV

Constructed by authors using the following WDI and
IFS data: bank deposit, financial system deposit, deposit
bank assets, private credit, and bank credit variables as
percent of GDP credit data are obtained from WDI; bank data are
obtained from IFS.

Gupta, Sanjeev and
Akitoby, Bernardin and Clements, Benedict and Inchauste Gabriela
(2004). "The Cyclical and Long-Term Behavior of Government
Expenditures in Developing Countries," IMF Working Paper No.
202.